Many of us fear an interruption in income flow when we need to carve time for something different such as raising a child, pursuing higher studies or starting a dream venture. If we have a cushion to fall back on, these decisions become much easier. Creating a fund for such contingencies is the first step in financial planning.
Our regular income is often at risk, and we may not see it. There may be the risk of losing our job, which is not an insurable risk. We could be wishing this risk away, even as we save and invest with a focus on long-term goals. A contingency fund acts as insurance against such income shortages.
Let’s find out how to start creating such a fund. The first step is to estimate the amount to be set aside. There are two methods to do this. One method is to simply provide for six months of income. Another method is to analyse the expenses of the household, identifying critical expenses needed to run the household. Rent, food, fees and utility bills, EMIs, insurance premiums and such mandatory expenses should be added up to arrive at a figure that will provide for the household for at least 12 months.
The next step is to decide where you will keep the contingency fund. A contingency fund should be readily accessible, safe and flexible. It should not be kept in illiquid assets like property, or in investments with a lock-in-period or penalty for withdrawal. Or in instruments such as stocks, where you might have to sell at a loss or lower profits if you need the money when the markets are down. The ideal choice for a contingency fund is liquid and short-term funds that earn steady returns with low volatility. These funds can be withdrawn whenever needed, and most funds refund the amount within one working day.
Next, start building the contingency fund. If we save 20 per cent of our income every month, we will need 30 months to build a contingency fund to see us through six months. To create a contingency fund faster, we can allocate existing investments -- invest lump sums such as bonus and incentive in it, and top it up whenever possible. Tightening our spending and moving any savings and excess income to the fund helps. An increase in salary can be used to create a contingency fund faster, before being used to enhance lifestyle spending.
Finally, we should try and define the situations that will warrant withdrawing money from the fund, and be committed to replenishing it as soon as possible. When there is a contingency, you can choose between taking a loan against the deposits, gold or mutual fund units, and liquidating the investment. When there is a risk to income, as in the case of a threatening pink slip, liquidating the asset is a better choice, as you won’t have a cash flow to repay any loans. Loans can be used if an alternative income stream is available and if the rate of interest on the loan is lower than the rate of return on the asset.
It is important to allocate money towards dealing with the emergencies that come up in life. It gives you the confidence to deal with situations and to take difficult decisions that can change your life. Make your money stand in for you – whether you are forced to take a break from work or you choose to take a sabbatical to do other things.